Thur Mar 15, 2007: Buying Put Options (AAPL)

If the stock market begins a deeper correction, some stocks that could suffer sharp losses are overpriced favorites like Apple Computer, which has enjoyed more than a tenfold increase over the last four years.

An April 95 put option on AAPL can be purchased for 6.50, or $650 per contract to control 100 shares.

Let's consider how far the stock would have to drop to double our money buying this put option.

Our April 95 put would double if it reached a price of two times 6.50 = 13.00 per contract. This would happen if before expiration day (April 20th, the third Friday of the month) AAPL dropped to 82 or lower.

If the stock was priced at 82, the put would be worth 13 because the put gives the owner the right to sell or "put" 100 shares of AAPL to the option writer at a price of 95. Buying the stock at 82 and selling it 95 would produce a profit of 13 dollars per share.

Even if the stock didn't drop that far, you could still make a profit on a smaller decline. Of course, you could lose money if the stock didn't go down much at all, or instead went up.

Quick quiz: Can you calculate the potential profits if AAPL dropped by one, two, or three points from its current price of 89.57 per share?

Answers:

A one-point drop would make the put in-the-money by (95-88.57) = 6.43 at expiration which would be a slight loss, even excluding commissions.

A two-point drop would make the put in-the-money by (95-87.57) = 7.43 at expiration, a gain of 93 dollars or approximately 14%.

A three-point drop would make the put in-the-money by (95-86.57) = 8.43 at expiration, a gain of 193 dollars or approximately 29%.

Note that you don't have to wait until expiration Friday to sell your put. You can sell it at any time prior to that. One rule to remember when buying options is to consider carefully and be slow before jumping in, but be ready to make a quick decision to get out when a profit is available, before it disappears. As an option buyer, time is not on your side and you have to take profits quickly to be successful. A bird in the hand is worth two in the bush. In other words, a smaller but sure real profit available now is often wise to take rather than holding on in hopes of making a big killing. That could cause you to lose your profit, and maybe more, if the stock bounces back up quickly.

One more caution: Since a move by AAPL above 95 would make the put worthless, only experienced option speculators who can afford to lose their entire investment in a short period of time should be involved in this risky strategy.

Until next time, best of luck with your option investments!